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Monday at 8;10am ET: *DIJSSELBLOEM SAYS BANKS ASKING FOR PUBLIC FUNDS ARE PROBLEMATIC

 

Defaults on the Rise into Lower Yields??

Moody’s Global High Yield Default Rate Takes Out it’s Long Term Average surpasses long-term average in May.

Breaking News: Deutsche Bank Economist Calls for Bailout

Cost of Deutsche Bank Credit Default Protection

Thanks to Central Banks, Bonds are Crushing Stocks in 2016

Junk vs S&P 500

 

Junk Bond ETF $JNK: +6.4% (w 6.1% yield)
S&P 500 $SPY: +4.2% (w 2.1% yield)

 

Moody’s trailing 12-month global speculative-grade default rate closed at 4.5% in May, surpassing its long-term average of 4.2% for the first time since August 2010, according to its latest global default monitor. Moody’s expects the rate to finish 2016 at 4.9%, and thereafter for upward default rate pressure to ease off.

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As we stated last year to subscribers, we believe the speculative grade default rate to hit 7% by the end of 2016, with materials and commodity sector bankruptcies leading the way.

Pure Financial Evil

Traditionally insurance companies in Japan and Europe would buy government and investment grade bonds, but today’s $12T of negative yielding government bonds are forcing them to reach for yield in junk bonds.

This week we heard from several sell side trading desks, we’re told negative interest rate torn insurance companies in Europe and Japan now piling into U.S. high yield paper.

After you implement the change in capital standards yields are basically at record lows.  This has become an evil, or perverse incentive for insurers to chase yield at the lower end of the rating spectrum.

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Cost of Credit Default Protection

The cost of credit default protection on some European banks is certainly on the rise.  Above CDS on subordinated financials, Deutsche Bank and UniCredit are shouting, WARNING.

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Credit vs Equities, What are they Telling Us?

When you look at equity prices of Intesa Sanpaolo, Deutsche Bank and UniCredit, we’re talking lows we have not seen since 2012.

Next, contrast with the relationship of subordinated credit default swaps on these banks vs the subordinated financials credit index.

Back in 2012, subordinated cds traded 310bps wide of subordinated financials index, while today only 230ish wide.  We believe the new bailout regime is a game changer, it speaks to evaporation risk to subordinated debt.

Stock Prices of European Banks
 Taking a look at a banks capital structure is even more important in today’s bail-in regime world.

Breaking News: Deutsche Bank Economist Calls for Bailout

“In Europe, the bailout does not need to be so large. A €150 billion program should be enough to help European banks recapitalize,”

“Europe is seriously ill and needs to address very quickly the existing problems, or face an accident,”

David Folkerts-Landau, Deutsche Bank Chief Economist, July 10, 2016

Banks in Europe should get the money for recapitalization following a similar bail out in the U.S., Deutsche Bank Chief Economist David Folkerts-Landau, tells Welt am Sonntag in interview.

Deutsche Bank pointed to the plunge in bank stocks is only the symptom of a larger problem, negative interest rates impact on bank’s profitability, slow growth and “dangerous” deflation.

• U.S. helped its banks with $475 billion, and such a program needed in Europe, especially for Italian lenders
  • Est. EU40b money needed by Italian banks “conservative”
• Bail-in using private money currently not doable, would hit people’s savings, may cause bank run
• Decline in bank stocks symptom of weak growth, high govt debt and close to “dangerous” deflation
• Europe “extremely sick” and must solve its problems quickly

Bloomberg

Folkerts- Landau is very concerned about Italy and the condition of local banks, the $45B number floated about if far too “conservative.”

A look at our best trading ideas for the second half of 2016, click here below:

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“The seventeen year river of reserve currency buildup is no longer flowing.”

Billionaire Fund Manager, David Tepper

 

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What used to be called a fringe selection of “perma-bears” has grown to a consensus.

Nine of 15 respondents in a Bloomberg survey at the end of June, including Standard Chartered Plc and Commonwealth Bank of Australia, predicted a China government-funded recapitalization will take place within two years.  Among those who provided estimates of the cost, a majority said it will exceed $500 billion, the smart money puts the tab well over $1T.  Hedge fund managers Kyle Bass puts the number near $10T.

If you do the math, there’s only one way out for China, a colossal currency devaluation.  As we stated to subscriber last July, a recapitalization will happen after the Chinese government comes clean with the true nonperforming loan figure.

Capital Flowing Out

In 2015, we witnessed China’s plunge in reserves of nearly $520B, in the last six months of the year the number has more than $400B, Reuters reported. Reserves fell by nearly $108 billion in December of last year, by nearly $100 billion in January and by around $28.57 billion in February of this year, before rising in March and April.

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Survey on China Bank Bailout

% of Respondents see a State Funded Bailout within Two Years

2016: 62%
2015: 41%

Bloomberg

In Q1, net capital outflows from China in the first quarter of 2016 were nearly $130 billion, per Goldman Sachs.  China’s four biggest banks now trade at 32% discount to book value, capital flows have even the Bulls concerned.  Over the last 6 months, Goldman’s outflow data on China is 50% greater than SAFE’s onshore FX settlement data, there’s far too much fuzzy math in China.

Goldman notes that around 70 percent of the net outflows were due to Chinese residents buying foreign assets and 40 percent due to repayment of foreign-exchange liabilities. This was offset by an increase in inflows by foreigners buying renminbi-denominated assets.

“While it is possible that some residents’ acquisition of foreign-exchange assets now is intended for repayment of foreign-exchange debt later, this does not appear to be the case for the second half of last year.  We think China has masked (understated) FX outflow data by $20B a month this year.”

Goldman Sachs

 

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The Fed is Holding a Smoking Gun on China’s Debt Explosion

The Fed’s easy money gravy train has made more than a few stops in China.  As the U.S. Federal Reserve expanded it’s balance sheet in the post Lehman era, a lot of companies in China have sucked in mountains of debt at unrealistically low interest rates.   Just before the Lehman 2008 crisis, $3 in debt to gave you $1 of growth in U.S.   Today, it takes $6.50 of debt to create $1 growth in China.  It’s a colossal failure of common sense all over again.

An analysis by the Bank for International Settlements (BIS), published in March, that suggested a big chunk of the outflows were related to unwinding a once-faddish investment: Buying yuan offshore as a play on expectations the Chinese currency would continue to appreciate against the dollar as well as the mainland’s slightly higher interest rates amid a yield-starved world, says CNBC.

Of the around $175 billion decline in cross-border loans to China in the third quarter of 2015, nearly half came from offshore depositors backing out of the yuan, the BIS said, citing data from banks reporting to it.

China debt load and banks are so interconnected.  Wealth Management Products WMPs are worth 27% more than China’s A-share equity market, this represents half of total bank deposits, explosive toxic growth.  China’s $3 trillion corporate bond market is “freezing up” amid rising defaults and canceled debt sales.  Over 18 publicly-traded Chinese bonds have defaulted so far this year, up from six in 2015.  More than 190 companies  have cancelled or delayed debt sales since the end of March.

Another big chunk came from Chinese companies paying down their foreign debt, said the BIS, which acts as a bank to central banks. It found that Chinese firms reduced their cross-border net debt over the third quarter, with the amount denominated in currencies other than the renminbi accounting for around $34 billion of the outflows.

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Goldman highlighted that it was skeptical of the offshore debt repayment narrative.

Chinese lenders are struggling with a growing, smelly pile of bad debt after flooding the financial system with cheap credit for years to prop up economic growth. Per Bloomberg, non-performing loans jumped by more than 40 percent in the 12 months ended March to 1.4 trillion yuan ($210 billion), or 1.75 percent of the total, according to government data. The figures are widely believed to understate the true scale of the problem, we believe NPLs were probably closer to 15 trillion yuan  ($2.5T) at the end of last year.

Pick up our latest list of 21 Lehman Systemic Rick Indicators here:

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From Fund Strategy:

The asset manager says it halted trading on the Standard Life Investments UK Real Estate Fund and its associated feeder funds at noon today. The suspension will last for at least 28 days and will remain in place until it is “practicable” to lift it, with the decision being reviewed at least every 28 days.

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Surge in Redemptions

SLI said the move has been taken in response to a rise in redemption requests “as a result of uncertainty for the UK commercial real estate market following the EU referendum result”.

“The suspension was requested to protect the interests of all investors in the fund and to avoid compromising investment returns from the range, mix and quality of assets within the portfolio,” a spokesperson from SLI says.

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The SLI fund has lower risk positioning, which should benefit investors, the spokesperson says. The fund had £2.9bn in assets at the end of May, with 13 per cent in cash. However, just as we saw in 2007, the liquidity mismatch between the fund and the assets it holds is leading to concerns.

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Join our Larry McDonald on CNBC’s Trading Nation, Wednesday at 2pm. 

In 2007, Larry led a team at Lehman Brothers to capture over $100m in bets against the subprime mortgage crisis.  Here’s what he has his eye on today.

“If we look at the Fed’s forecast of where they think their Fed Funds Rate will be at the end of 2016, it’s up at 1.625%.  That’s five 25bps hikes over the next year?  Look for this number to come down substantially, the US 10 Year note is heading below 1.50%.”

Bear Traps Report, September 2015

 

The Longest Runs with Rates Near Zero

1932-1953: 21 years

2008-2016: 8 years

2001-2004: 3 years

 

The U.S. has had near zero short-term interest rates before. The period of 1932 to 1953 was defined by rates that were between zero and 2.1%. The last time we hit the zero bound, we stayed very close to it for upwards of 21 years. This is not something you hear often from economists these days.

Lower yields for longer periods of time bring out the animal spirits in investors, the reach for reach for yield gets more excessive EVERY minute interest rates are kept at ridiculously low levels.

U.S. Speculative-Grade Corporate Default Rate Increased To 4.1% in May, highest since September 2010, which saw the rate at 4.2%.

 

U.S. Household Net Worth

Central Bankers Giveth, but they Will Take it Away

The main reason central banks raise and lower rates is to shift consumption around and smooth out periods of stagnation. The Fed’s dual mandate of non-accelerating inflation and full employment defines the characteristics of the smoothing that society wants to see.

 

The number of  U.S. corporate high-yield bonds on negative rating watch has risen 26 percent in the past year due to increasing leverage and a poor liquidity outlook.  As of June 30, 2015, the list of corporate high-yield bonds on negative watch by one of the three major rating companies as of that date was 119.  Today, this number has surged 26 percent to 149 bonds, even as yields have fallen.  Lower credit quality and lower yields is the evil side effect of modern central banking.

 

 U.S., Italy and Spain 10 Year Bonds

In a powerful move, Spain’s 10 year bonds have plunged in yield.  Last week at 1.63% to 1.14% as of Friday’s close.  Mario Draghi and the ECB brought out the fire hose to contain markets.  Just a leaked story to the press over a possible “Capital Key” expansion had shorts running for cover and buyers stampeding in.  It’s amazing how regulators are putting stock market players in jail for trading on “inside information” while central bankers are creating their own every other week.  Expanding the capital key would allow the ECB to buy even more, low credit quality, periphery (Spain, Italy) debt.  Today, investors receive 0.30% more interest buying a U.S. 10 year bond over Spain’s 10 year.  Front running the ECB has become a national pastime in Europe.  As someone who sat on the deck of the Titanic that was Lehman Brothers, this is pure evil, central bank induced moral hazard gone rogue.

Since 2008, $33T of wealth has been created in the USA.  The Trillion Dollar question?  What is the U.S. ‘s aging population doing with all this money?  Buying bonds that have doubled in value?  Lending money to commodity companies (oil), financing more exploration and excess supply?   We have a global, aging population positioning capital in places it just shouldn’t be, all because of central bankers.

U.S.  Population 45-64

There are powerful dynamics hidden inside today’s bond and commodity bubbles that once again clueless central bankers are missing.  There are nearly 4m more Americans age 45-64 today than there were for years ago.  Where are these high net worth investors being forced to put there wealth?  Developed markets around the globe are experiencing the same problem.  Aging populations after years of wealth creation equal a lot of investors with limited choices, so they reach for yield. Investors are putting capital in places it just shouldn’t be and central bankers are holding the smoking gun. They successfully blamed Wall St. for the financial crisis and hid behind the shadow of a tragedy, they will not be so fortunate when markets turn on them again.

 

Everyday nearly 11,000 people in the USA Turn 65

% of Population Over 65 of Age

Japan: 28%

Germany: 22%

Spain: 22%

Italy: 22%

USA: 15%

Bloomberg

Low rates pull consumption and investment forward and allow projects to be undertaken that otherwise would have to wait. Some people call this stealing economic activity from the future, but we must keep our eye on the incentives created by Fed policy.

 

U.S. 30 Year Mortgage Yield vs. the S&P Case Shiller Average Home Price

This is a very interesting look at the S&P / Case Shiller U.S. Home Price Index vs the U.S. 30 Year Mortgage Rate. We must learn from financial history, clearly Fed policy had a heavy hand in inflating the U.S. housing bubble. What are their policies disrupting today? Over the years, each financial crisis experiences a metamorphosis into another serpent, another beast. We must prepare for what is coming at us.

On the other hand, higher rates make debt more expensive and push consumption and investment out. Over the last year, most economist have felt the Fed is looking to “tap the brakes” on the improving U.S. economy.   Wall St has been wrong yet again, they’re the gang that can’t shoot straight.

 

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Excessive Debt: Handcuffs Or A Noose?

The other pressing issue is high debt levels. The Fed is in no hurry to hike rates with debt levels so high in the post-Lehman era. The U.S. hit its debt ceiling in March of 2015, at $18.1 trillion, but the devil is in the details, or what’s called interest costs as a percentage of federal spending. As you can see below, net interest outlays are on course to more than double by 2017 from 2005 levels. Interest costs on the staggering U.S. debt load, added together with government entitlement spending, is nearing 71% of Federal spending, compared to 26% in the early 1960s. Is this sustainable?

 

U.S. Government Net Interest Outlays

2017: $335B
2009: $190B
2005: $150B

*Data from CBO

 

USA National Debt 2009-16

It’s pure comedy to listen to the national media in the U.S. talking up the risk of a Donald Trump Presidency to the National Debt.  Debt has exploded under Obama and Congressional policies since 2008.

 

Get our latest trade ideas heading into the 2016 election here;

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“EU Banks are in a world of Brexit pain, we are taking advantage of fear. EU financials are a screaming capitulations Buy today. Our 7 factor capitulation model is giving us a very strong buy reading, even stronger than the one we had in February. The Jo Cox tragedy created a false reality, last week investors piled into buy the Pound and EU banks, a classic student body left. This has created an amazing short term buying opportunity for the brave investor who appreciates risk / reward.”

The Bear Traps Report, June 27, 2016

 

One of the more prominent reasons we were buying equities into Monday’s plunge was the fact that in recent years, as markets become stressed, central bankers float new creative ideas into their favorite media channels. The net result is a consistent and fairly predictable student body left, student body right market movements.

The steepness of the VIX futures curve is one of our 21 Lehman Systemic Risk indicators. The speed of the steepening process is a key element to risk management. In all market panics, the front month VIX future trade rich to the outer months. As you can see above, on Monday of this week the VIX futures curve was flat, move into slight backwardation. We used this as a signal to bet long equities (see our Bear Traps Trade alert from Monday, June 27).

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The CBOE Volatility Index is on pace for its biggest weekly decline in history as investor nerves settle following the U.K.’s decision to exit the European Union. Since the so-called S&P 500 fear gauge surged 49 percent last Friday, it’s slid in each of the last five days for a 42 percent decline in the period. The VIX is stabilizing after last week’s 33 percent increase, which was within the 97th percentile of gains for similar periods. – Bloomberg

On May 29th, we recommended clients get long volatility as complacent equity markets were not appreciating coming Brexit risk.

Lehman Memories

Over the last 10 days, the S&P 500 has moved 1.3% or more (up or down) 6 days in a row. Hasn’t hit 7 since Dec 2008.

Bloomberg

 

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Join our Larry McDonald on CNBC’s Halftime Report Friday at 12:30pm

“Central banks around the world are having more and more influence on the markets. Many people are trading off of anticipated policy moves and the crowded trades are even more profound. However, the sentiment of investors making bets on the “great divergence” has reached a fever pitch.  Fed funds futures are expecting at 78% of a 25bps rate hike, far too many people are on one side of the boat.  We believe credit risk will veto the Fed policy path next year.  We do not see rate hikes coming in 2016. We implore you to buy the gold miners GDX and long U.S. Treasury bonds.”

The Bear Traps Report, December 9, 2015

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*ITALY SAID TO WEIGH $44 BILLION INJECTION IN BANKS AFTER BREXIT

Italy’s banks we’re substantial under-performers Friday, off nearly 20% over the last 3 trading sessions.  As we stressed last year to subscribers, zombie banks in Europe hold over $1T of bad debts, Italy’s stake of smelly loans is near $400B.

Italy is considering a 40 billion euros ($44 billion) bailout of it’s banking system. 

Fresh capital for the country’s banks, Il Fatto Quotidiano reported Monday, citing government and financial sources it doesn’t identify. – Bloomberg

The government would sell debt to fund the capital injections and is talks with the European Commission, Il Fatto said. Governments can provide funds directly to banks in exceptional circumstances of systemic stress, which Italy would cite as a reason for its intervention in the aftermath of Brexit, the Italian daily newspaper reported.

Italy’s lenders are over-loaded with 360 billion euros of bad debt, while profit is also squeezed by record-low interest rates and sluggish economic growth.

 

The plunging in financial markets continued Monday.

The pound extending its record one-day selloff after the U.K.’s vote to exit the European Union threw British politics into turmoil, fueling anxiety over the decision’s impact on the wider global economy.

China weakened its currency fixing by the most since last August as global market turmoil spurred by Britain’s vote to leave the European Union sent the dollar surging.

The People’s Bank of China set the reference rate 0.9 percent weaker at 6.6375 a dollar. A gauge of the greenback’s strength jumped 2.4 percent in the past two days, the most since 2011, as the British pound and the euro tumbled. The yuan dropped 0.3 percent to 6.6473 as of 6:44 p.m. in Shanghai, heading for its weakest close since December 2010. – Bloomberg

Front Month VIX Futures surged up to 22.50 while 8 months out stand at 22.67, the curve is nearly inverted, a classic sign of severe panic.

The rout in riskier assets picked up where it left off Friday, with the Australian dollar slipping with the euro as as U.S. and Japanese index futures fell with New Zealand shares. The Norwegian krone tumbled more than 2 percent as oil dropped a second day. Sterling sank beyond $1.35, extending losses near weakest level since 1985 as investors face months of uncertainty over Britain’s future amid turmoil within the two major political parties and Scotland agitating anew for independence. Angst boosted the yen and gold, amid demand for havens following the worst day for global stocks in almost five years.

Pick up our Brexit trade ideas playbook below, just click on this link:

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Join our Larry McDonald on CNBC’s Halftime Report Friday at 12:30pm

“Central banks around the world are having more and more influence on the markets. Many people are trading off of anticipated policy moves and the crowded trades are even more profound. However, the sentiment of investors making bets on the “great divergence” has reached a fever pitch.  Fed funds futures are expecting at 78% of a 25bps rate hike, far too many people are on one side of the boat.  We believe credit risk will veto the Fed policy path next year.  We do not see rate hikes coming in 2016. We implore you to buy the gold miners GDX and long U.S. Treasury bonds.”

The Bear Traps Report, December 9, 2015

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The clowns, otherwise know as “stock market cheerleaders” are quick to remind us every time equities near record highs.  Over the last 2 years, we’ve heard countless times how “we’re breaking out into record territory.”

Its so disingenuous. We must all deal with the reality of what were up against.  Since the Federal Reserve started to taper their monetary goodie bag, stocks have gone no where, while a few names FANG (Facebook, Amazon, Netflix and Google) have hogged all the returns.

S&P 500

Facebook is up 51% since November 7, 2014 while the S&P 500 is unched.

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Russell 2000

Amazon is up 98% since October 29, 2013 while the Russell 2000 is unched.

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Dow Jones Industrial Average

Google is up 23% since October 30, 2014 while the Dow Jones Industrial Average is unched.

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